Love Letter – April 9, 2018

April 9, 2018

U.S. – China protectionist trade rhetoric adding to short-term volatility, but our positive thesis intact

Though markets are generally rational, they occasionally do crazy things.” (Warren Buffett, Berkshire Hathaway 2017 Annual Report, February 24, 2018)

Despite the strongest global economic growth in many years, capital markets have been volatile and performed poorly so far in 2018. As of the close on April 6, most global equity markets were in negative territory YTD and the MSCI World equity index was down 2.4% YTD. While inflation worries and higher interest rates triggered the sell-off in early-February, protectionist trade rhetoric emanating from the White House, and profit-taking in the technology sector have contributed to further deterioration in investor confidence in recent weeks (exhibit 1).

Quite contrary to media headlines on trade, geopolitics, and day-to-day swings in the marketplace, we continue to view fundamentals as positive, valuations as reasonable, and risks worthy of monitoring but manageable. In this newsletter we outline several reasons to maintain the course of a diversified investment portfolio strategy.

Rationales supporting our positive thesis for 2018

  • Valuation cheaper now than before the election: Despite a 21.7% gain in the S&P500 Index since the November 8, 2016 U.S. election, U.S. stocks have actually gotten cheaper due to strong corporate earnings growth. As of April 6, this benchmark index is trading at 16.1x forward 12-month forward estimated earnings versus 16.5x just before the U.S. election.
  • Volatility is higher than 2017, but back to 20-year average: The recent spike in market volatility comes after 2017’s record low volatility. Even so, April 6’s reading of U.S. equity market volatility is within 5% of the 20-year average. This suggests that volatility conditions, albeit gut wrenching for some, have returned to historically normal levels. Investors should also recognize that intra-year equity market performance typically moves within a range rather than a straight line. Indeed, dating back to the mid-1970s the S&P500 has averaged an annual return of 10% but has declined by an average of 9% intra-year (exhibit 2). In Canada, a similar analysis indicates average historical equity gain of 8%, with an average intra-year low of 10%. This suggests that the current drawdown is completely normal in the historical context and should not be a concern for investors with medium- to long-term horizons.


  • Best pace of global growth in five years: The median forecast for 2018 year-over-year global GDP growth currently stands at 3.8%, and has been revised higher five times during the past 12 months. Compared with 2017’s 3.43% growth rate, achievement of 2018’s forecast would represent the fastest pace since 2013.
  • Consumer confidence at multi-year highs: Representing 69%, 56%, and 40% of overall economic activity in the U.S., Europe, and China, respectively, the consumer is the single most important factor driving GDP growth. In each of these three most significant economies, consumer confidence remains close to 14+ year highs, suggesting that the global economy’s health has a strong basis. In each of the past three major equity market downturns dating back to the early-1990s, a meaningful deterioration of consumer confidence preceding a stock market sell-off. Current levels of consumer confidence don’t indicate an imminent decline of global equities.
  • Business confidence also strong: Second to the consumer, business confidence is also a crucial gauge of overall economic health. Monthly Purchasing Managers’ indices within the largest economies, a proxy for business confidence, have also steadily recovered and are well positioned to support GDP and corporate profit growth.
  • Interest rates rising very gradually: Global interest rates are biased higher, but central bankers are being careful not to raise short-term rates aggressively. We think monetary policy conditions in the U.S. and Europe remain accommodative for further economic expansion. Based on the current forecast path of U.S. interest rates, we think rates could begin to slow the economy in the second half of 2019. Short-term rates in Europe remain in negative territory and thus the runway for economic expansion appears longer.
  • Rhetoric on trade unlikely to result in an all-out global trade war that could sink to the global economy: Aggregate U.S.-China trade was estimated at US$564 billion in 2017, representing 2.9% of total U.S. GDP and 4.7% of Chinese GDP. While causing short-term anxiety for investors, we think the U.S.-China tariff spat is worthy of monitoring but ultimately we believe it’s a precursor to much-needed negotiations. Unless trade relations deteriorate significantly and spread globally, we think the impact on the global economy is relatively low. Furthermore, we think Trump’s pattern of bold rhetoric followed by concessions and a deal should alleviate concerns of a major trade war that could harm both China and the U.S.
  • Sentiment on Canada already low even as conditions appear to be stabilizing: The Canadian equity market has lagged global peers since the U.S. election but underlying conditions appear to be stabilizing. After declining materially since mid-2017, home prices in major markets have started to show signs of stabilization. Employment gains in Canada have moderated from the frantic pace of 2017, but the national unemployment rate of 5.8% remains at a 10-year-low. Canadian oil prices have started to narrow the gap versus WTI and Brent benchmarks. Compared with the current federal and provincial positions, the “right vs. left” political climate is poised to shift directionally to the right over the next 12-18 months.
  • Technical indicators approaching oversold conditions: Short-term technical market indicators suggest that the current sell-off may have reached a near-term limit.

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